Notes and Analysis From GE’s Investor Update

“You can’t grow long-term if you can’t eat short-term. Anybody can manage short. Anybody can manage long. Balancing those two things is what management is”
      -Jack Welch

As everyone knows, this has been a tough year for GE shareholders.  GE’s stock is down 40.8% year-to-date (thru 11/17) on a total return basis.  By comparison, the S&P 500 has delivered a 17.3% positive total return.  GE’s stark underperformance reflects both the decline in its earnings expectations – its 2017 operating EPS guidance (industrial operating + verticals) has been cut from $1.60-$1.70 at the beginning of the year to $1.05-$1.10 currently – and now the halving of the dividend.  2018 has been characterized as a “reset” year.  Management currently anticipates 2018 adjusted EPS of $1.00-$1.07, which is roughly half of the previous target of $2.00.  According to management, the change in performance and outlook reflects primarily sharply reduced expectations for GE’s Power business and continued weak performance in Oil & Gas and Transportation.

At GE’s Investor Presentation on Nov. 13, Chairman and CEO John Flannery presented the conclusions of his review of GE’s businesses and the initial framework of his plan to remake GE.  The plan includes the following:

  1. Focus GE’s business portfolio on core industrial businesses.  These are Aviation, Power and Healthcare.  GE has is targeting more than $20 billion of asset and business divestitures, including Transportation, Industrial Solutions, Current & Lighting and ten or more other smaller transactions.  It will look to monetize its 62.5% ownership interest in BHGE (but probably will not execute on this until July 2019 or later, unless it is able to change the terms of the merger agreement).
  2. Seek another $2.0 billion of cost savings through restructuring actions.  GE is shrinking its Global Research Organization from five research centers of excellence to two, (keeping Niskayuna, NY and Bangalore, but closing Munich, Shanghai and Rio de Janeiro.)  It is scaling back its Global Growth Organization and refocusing its remaining efforts on emerging markets.  It is also refocusing its Digital initiatives, concentrating primarily on GE’s internal operations, rather than continuing the development of a broader-based digital industrial platform.  Besides these efforts, the company will look to continue to drive cost out of its existing businesses, including right-sizing the operations to current and future expected market opportunities.
  3. Be more disciplined in capital allocation.  This is a key function of GE Corporate.  GE has not generated the returns that management expects from its businesses.  Going forward, approvals for organic investments will be based upon a realistic assessment of the market potential.  Improving cash flow generation is a priority.  So is disciplined M&A.  Besides its planned divestures, GE will seek only smaller, “tuck-in” acquisitions that have the potential to deliver immediate returns.  (Later on, it may consider larger M&A deals.). In 2018, GE will pursue greater balance in its capital allocation.  It will still fund R&D at 4% of revenue, while reinvesting in its businesses at the rate of depreciation.  Cutting the dividend will free up $4 billion.  The company will make a $6 billion voluntary contribution to its principal pension plan, funded with debt.  GE does not expect a dividend from GE Capital in either the second half of 2017 or in 2018.
  4. Streamline decision-making, performance metrics; raise accountability, increase transparency, and be rigorous in execution.  GE is reducing the size of its Board of Directors from 18 to 12, with three new members to be added in 2018.  GE will be rigorous in its planning, target-setting and performance reviews, but utilize simplified metrics in its evaluation of businesses.  Management’s compensation will be tied more closely to stock price performance.  Yet, it will also seek to align compensation with long-term goals and manage for the long-term health and performance of the company.

While GE’s stock price performance this year has been dismal, it is worth noting that GE outperformed the S&P 500 on a total return basis from the stock market bottom in March 2009 until the end of 2016.  By my calculations, GE stock delivered an average annualized return of 24.3% during that period, much better than the S&P 500’s 19.1% total return.  About 200 basis points of that “alpha” was earned coming off the bottom during the month of March 2009.  GE outperformed the S&P in five of the eight years from 2009 to 2016.  One year, 2011, was essentially a tie.  The stock underperformed the market in 2014 and 2016.

The topping out of GE’s performance from 2014 to 2016, was mostly due, in my opinion, to the sharp decline in the price of oil, which put considerable pressure on GE’s Oil & Gas business.  Up until 2017, investors were happy with GE’s strategic direction, which concentrated on liquidating most of GE Capital to concentrate on the industrial core.

Trian Partners.  Up until the end of 2016, Trian Partners, the activist investment group that initiated a stake in GE in 2015, was also happy with GE’s direction and the performance of its share price.  In its 2015 white paper, Trian praised GE CEO Jeff Immelt for the steps that GE had taken to narrow GE Capital’s mandate, refocus on the industrial businesses and reduce operating costs.  For the record, Trian’s happiness was supported by the performance of GE’s stock, which earned a total return of 27.5% in 2015, much better than the S&P’s 1.4% total return.

Despite the poor performance of GE’s stock in 2017, I see no evidence that Trian put any pressure on GE to change its CEO or rethink its strategy.  GE has issued no statements challenging Trian’s input.  In contrast to Procter & Gamble, which mounted an aggressive campaign to keep Trian off its Board, GE invited Ed Garden of Trian to join its Board.

The changes currently underway at GE under new CEO John Flannery are apparently consistent at least in the short-term with the steps that Trian would advocate as an activist investor seeking a superior investment return in a one- or two-year time frame.  Whether that approach is best for GE over the long-term remains to be seen.

In its white paper, Trian anticipated that GE’s stock would reach $40 per share on $2 of earnings.  When it gets there (or when it becomes evident that GE will not be able to get there), Trian will most likely exit its position.

Private Equity Mindset.  Mr. Flannery seems to be bringing a private equity mindset to GE.  During his career, he was a deal-maker at GE Capital. Since becoming CEO, he has spoken on several occasions of wanting to be in businesses where GE can add value.  As with private equity investors, once GE adds that value, the business would then be a candidate for divesture.

Mr. Flannery’s more focused approach to capital allocation, including a “more realistic” assessment of potential market opportunities for new products and services, speaks to a desire to improve investment returns in the short- to intermediate term.  That means running the businesses as lean possible, cutting overhead costs, eliminating or scaling back “non-productive” research and reducing the capital devoted to new product initiatives.  It remains to be seen what the long-term impact of this management change will be.

Transportation.  This private equity approach is illustrated in GE’s decision to divest the Transportation business; whose primary product is railroad locomotives.  GE has been in this business for more than a century, even through the Great Depression.  In his Nov. 13 presentation, Mr. Flannery acknowledged that the business has a strong market position and has adjusted well to the recent decline in demand.

He offered three reasons for the decision to divest: (1) GE sees weak demand for locomotives for the foreseeable future, especially in North America; (2) GE is exploring various options for the divestiture, including a full or partial spin; so GE may still have continuing involvement in the Transportation business; and (3) the divestiture would simplify the company and improve GE’s focus on its three “core” businesses: Aviation, Power and Healthcare.

Despite generating only 4.2% of GE’s 2016 Industrial revenues, the Transportation business is quite profitable, with an 8% operating profit margin and 24% pre-tax return on assets in 2016.

I don’t buy the focus argument.  GE has operated successfully in modern times with business portfolios that have been much more complex than today’s line-up. GE management thrives on complexity.  Focus is therefore a short-term mandate and not a permanent one.  If it were permanent, Mr. Flannery would not have said that he will consider big M&A transactions in due time.

Locomotives are big, complex machines, with lots of parts and sensors, and consequently lots of opportunity to apply digital, additive and other technologies to improve performance and reduce operating costs. Locomotives, in my view, fit the profile of an ideal GE business.

During the Nov. 13 presentation, John Joyce, the CEO of GE Aviation, which oversees GE’s investment in additive manufacturing, reported that GE engineers using additive have shrunk the size of the radiator and fan system on GE locomotives, freeing up cab space that could be used for batteries.  This may enable future hybrid diesel-electric upgrades of existing locomotives that could reduce fuel costs by as much as 23%.

With its leading market position, strong services business and the possibility of future upgrades and new designs, the Transportation business should attract buyers, even with the weak demand outlook for new locomotives.  GE will presumably still sell technology and other services to Transportation and it might even structure the deal with some form of continuing equity interest.  With $4.4 billion of assets and a current estimated EBITDA run rate of $1.1 billion, GE is almost certain to book a profit on the sale, most likely in excess of a few billion dollars.  By selling now, GE will get cash that it can redeploy elsewhere and avoid carrying a business in its consolidated financial statements whose earnings are not growing (and probably declining).

Oil & Gas.  The desire by GE to monetize its 62.5% stake in Baker Hughes (BHGE), eighteen months before it is allowed under the merger agreement to divest and perhaps before the next upcycle in the oil services industry begins, also illustrates GE’s heightened emphasis on investment returns.

The oilfield services business also fits GE very well.  Over the years, GE has brought its turbine and electric motors expertise and even its MRI technology to Oil & Gas to build, expand and upgrade its product and services offerings.  It has also expanded through acquisitions, the latest of which, Baker Hughes, creates a “full stream” service provider, especially for the offshore.

By divesting its stake in BHGE soon, GE might side-step a possible double-dip recession in the oil patch, but it would also lose some of the potential upside from an industry rebound.  Competition is tough, but BHGE still has the potential to raise its long-term competitive advantage over time by integrating more completely GE’s digital tools into BHGE’s products and services.  It is still possible for GE to add value to BHGE.

As a first step, GE might want to take its ownership stake below 50%, so it can deconsolidate BHGE. This would most likely be accomplished by spinning off or selling outright at least 20% of its investment, equal to 12.5% of BHGE’s equity.  That 20% portion is currently worth $4.4 billion.  At the current share price of around $30.60, I estimate that GE would book a loss on any sale of its stake in BHGE of about $3.67 per share.  (I estimate the book value of GE’s investment in BHGE to be $34.27, equal to the amount by which BHGE wrote up its non-controlling interests – $24.6 billion – to reflect GE’s 62.5% stake in BHGE divided by GE’s holding of 717 million BHGE Class B shares)

The deconsolidation of BHGE would most likely improve GE’s return on assets by taking nearly $55 billion of assets off its balance sheet and replacing them with an equity method investment of less than $18 billion.  I estimate that it would also improve GE’s return on its investment because the denominator of the ROI calculation would decline by a greater percentage than the numerator.

Cuts to R&D, NPI and GGO.  Another key aspect of the private equity mindset is the push to focus internal spending, especially for research and development and new product introductions (NPI) on opportunities that have a higher probability of generating near-term returns.  As noted, GE is cutting back spending in part by closing three of five of its Global Research Centers (GRCs) and scaling back its Global Growth Organization (GGO) to focus mostly on emerging markets.

In his 2016 letter to shareholders, former CEO Jeff Immelt said that GE has “the finest global footprint of any company in the world.”  Yet, the GGO and GRC spending cuts signal at least a step back from GE’s go-to-market strategy outside the U.S.

Although the GRCs may not generate many near-term sales opportunities, they do represent a commitment by GE to develop local products for local markets.  For example, GE’s portable ultrasound product, which has generated spectacular sales and profits over many years, was developed outside the U.S. in large part to meet the needs of doctors traveling from village to village to see patients.

The GGO has also facilitated significant sales for GE outside the U.S., by increasing the company’s presence in local markets.  Case in point: GE is building a brilliant factory in India to fill an order for 1,000 locomotives there.

At the Nov. 13 meeting, Mr. Flannery emphasized that these were modest reductions overall and that GE is still committed to global growth and R&D, including its corporate research function and the concept of the GE Store (where its businesses share technology and technological advances). GE pledges to maintain a strong local presence in Africa and other emerging markets, where it sees good long-term business opportunities; but it has pulled back in other areas, where it does not see good opportunities for growth.

GE is also scaling back its efforts to introduce new products.  It will still seek to upgrade and replace existing products, but it is on a mission to cut expenditures on new products that do not have a reasonable chance of success.  It is also planning to cut the cost of NPIs to eliminate wasteful spending.

“Change before you have to.”  – Jack Welch

Cutbacks in the GCR, GGO and on NPI’s almost certainly figured prominently in the decisions of GE Vice Chairs John Rice, who headed the GGO, and Beth Comstock, who led Business Innovations, to retire.  GE’s tilt towards short-term profitability may run the risk of compromising longer-term growth. The challenge, therefore, is to find the proper balance. Eventually, however, the proper balance may be determined by geopolitical developments or a global economic downturn that will for a time reduce growth opportunities both in the U.S. and abroad.

The Ability to Remake the Company.  Over the years, I have often marveled at GE’s ability to identify new business opportunities and scale them up quickly, through both internal development and acquisitions.  Renewables, Oil & Gas and Digital are examples of this, even though the growth of Oil & Gas occurred over more than two decades.

GE also has the capacity to scale down its businesses quickly, as it demonstrated recently by winding down its investment in GE Capital and also by the ways that it adjusts manufacturing capacity quickly in businesses like Transportation as the downside of the business cycle takes hold.

While I am not an insider, I surmise that this ability for such a big company to be able to move fast is part culture and part management expertise; but it also requires a certain amount of organizational flexibility, which in turn is gained by having “excess capacity” that is used to create or identify opportunities and implement plans.  Even though that excess capacity is productive, it does not generate revenues and so it reduces the company’s near-term profitability.

Despite announcing measures that could result in the elimination of three of its eight business segments, there were calls in the analyst community and in the business media for GE to do more.  Selling or spinning off more businesses and making deeper expense cuts could improve near-term shareholder returns more quickly, but it would also risk changing the fundamental nature of General Electric more radically, in ways that I believe would have negative long-term implications for both the company and the U.S. economy.

Mr. Flannery began his Nov. 13 presentation with a slide that highlighted GE’s ability to leverage its technical strength to remake the company multiple times over its 125-year history.  By shifting the company’s focus toward achieving shorter-term goals, there is a risk that GE may not be able to remake itself as successfully in the future.

Nevertheless, as long as the global economy holds up, I have little doubt that Mr. Flannery will achieve his objective of improving the company’s profitability and near-term growth outlook in 2019.  This, in turn, should allow GE’s stock to recover much, if not all, of the ground that it lost, providing shareholders with superior returns over the next year or two. For one, Mr. Flannery is starting now from a low base of earnings, share price and dividend rate.  The problems that led to the cuts in earnings and cash flow guidance seem fixable in a year’s time.

While Trian Partners’ $40 price target looks like a stretch from here, I think that a rebound in earnings back to or above $1.50 per share would allow the stock to revisit its previous high of $31.66, set in July 2016.  Hopefully, Mr. Flannery and his team will be able to achieve their financial objectives while still preserving the company’s long-term fundamental strengths.

November 21, 2017, revised November 22, 2017.

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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